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1. INTRODUCTION
Fiscal policy refers to governments efforts to influence the direction of the
economy through changes in taxes or expenditures. Optimal fiscal policy in Pakistan and
in other developing countries plays a pivotal role in growth process and, hence, serves as
a vital instrument for economic growth. The efficacy of fiscal policy in improving
economic conditions in the long run is, however, a controversial issue and needs further
investigation.
In conventional model, a federal tax cut without a corresponding reduction in
federal expenditures will encourage consumption expenditures and interest earning s
due to increase in personal disposable income. Contrarily, according to Ricardian
Equivalence Theorem (RET), the same change in fiscal policy will not result in any
of the above mentioned macroeconomic impacts. In other words, a reduction in
deficit-financed federal tax cut will not affect macroeconomic outcomes [Saxton
(1999)].
The empirical literature on the effects of fiscal policy on Pakistans economic
growth is still at its infancy, we surmise. Shabbir and Mahmood (1992), Iqbal (1995,
1994, 1998), Khilji and Mahmood (1997) have concluded that fiscal deficit is one of the
significant variables that affects economic growth in Pakistan. Haq (2003), on the other
hand, has argued that fiscal deficits do not have any effect on key macroeconomic
indicators such as investment, inflation and GDP growth. The impact of fiscal policy on
economic growth can also be demonstrated and explored through transmission
mechanism; it affects economic growth via demand and supply sides. According to
Khalid, et al. (2008) fiscal policy is considered to have dynamic transmission
mechanism, as it carries longer policy lags for different macroeconomic variables and
hence, it has different impacts on key macroeconomic variables.
Recognising the importance of sound fiscal policy, the present study explores the
link between fiscal policy and economic growth for Pakistans economy for the period
19722008. The study also examines the effectiveness of fiscal policy in different
political regimes. Using dynamic model and various econometric techniques, this study
tests the significance of various empirical models. The study also imparts some policy
recommendations for the development of sound fiscal policy in Pakistan. This study is
the first empirical analysis on the effectiveness of fiscal policy and its impact on
economic growth in Pakistan.
The rest of this study is organised as follow: Section 2 presents the summary of
review of literature on the effects of fiscal policy on economic growth in different parts
of the world. Section 3 presents the model specification and methodology. Section 4
represents the empirical findings and the last section provides concluding remarks and
policy implications.
2. LITERATURE REVIEW
The macroeconomic relationship between fiscal policy and economic growth has
long fascinated economists. Unfortunately, analyses of that relationship have
frustrated empiricists for almost as long. One root of that frustration is the array of
possible policy indicators [Fu, et al. (2003)].
A large number of studies have been carried out to examine the impact of fiscal
policy variables on economic growth, investment, consumption, inflation, exchange rate,
external deficit and other macroeconomic activities [Landau (1986); Hoppner (2003);
Perotti (2005), Amanja and Morrissey (2005); Falk, et al. (2006); Rezk (2006); Castro, et
al. (2006); Fatas and Mihov (1998); Sinha (1998); William and Orszag (2003); Claus, et al.
(2006) and Kukk (2006)]. Government spending, tax revenues and budget deficits as fiscal
policy variables have been used by these authors and found different responses of
macroeconomic activities to fiscal innovations. According to Hoppner (2003), Claus, et al.
(2006), Esau (2006), Heppke-Falk, et al. (2006) and Castro, et al. (2006), shocks to
government spending positively affect GDP growth rate, whereas shocks to taxes inversely
affect GDP growth rate. Furthermore, GDP growth rate responds negatively to budget
deficit in the long run [Balassa (1988); Iqbal and Zahid (1998); Jafri, et al. (2006)]. Many
researchers [Barro and Sala-i-Martin (1995); Sala-i-Martin (1997); Mendoza, et al. (1997);
Tanzi and Zee (1997); Kneller and Gemmell (1999); Odedokun (2001); and Bose, et al.
(2003); Amanja and Morrissey (2005); Romero de Avila and Strauch (2007)] have used
fiscal policy variables in the growth equations and have found their significant contribution.
The rising budget deficit has been considered as one of the main constraints to economic
growth [Iqbal and Zahid (1998); Fischer (1993); Easterly and Rebelo (1992); Levine and
Zervos (1993); Barro (1991); Mwebaze (2002) and Balassa (1988)]. From the relevant
literature it is clear that fiscal policy affects economic growth. However, the sign and
magnitude of the effects of different tools of fiscal policy are ambiguous.
Only few studies have examined the effects of fiscal policy on specific
macroeconomic variables in Pakistan [Ahmad and Qayyum (2008); Haque and Montiel
(1991); Khalid, et al. (2008)]. Few studies have included budget deficit in growth
equations and have found that budget deficit is one the significant variables affecting
Effects of Fiscal Policy on Economic Growth 499
economic growth [Shabbir and Mahmood (1992); Iqbal (1994, 1995, 1998); Khilji and
Mahmood (1997)]. As far as theoretical work regarding the relationship between fiscal
policy and economic growth is concerned, the most notable work has been done by
Trevala (2005) and Blinder and Solow (1972). Tervala (2005) argued that fiscal growth
raises the output of non traded goods and crowds out private consumption of non traded
goods. However, Blinder and Solow (1972) argued that in the simplified ISLM
framework the long run sign of the pure fiscal multiplier is undermined a priori, fiscal
policy only acts perversely in unstable system.
3.2. Methodology
This study concentrates on the ADF and PP and NgPerron unit root tests. To test
the long run relationship, this study uses the robust econometric technique,
Autoregressive Distributed Lag model (ARDL), popularised by Pesaran and Shin (1998),
and Pesaran, et al. (2001).
The error correction version of ARDL model is given below for the above given
Equation (1).
p p p
Yt 1 Yt i 2 FPt i 3 X t i 1Yt 1 2 FPt 1 3 X t 1 (2)
i 1 i 0 i 0
Where Y represents real GDP growth rate, FP represent fiscal policy variables such as
fiscal deficit as a percent of GDP (FD), current expenditures as a percent of total
expenditures (CE) and development expenditures as a percent of total expenditures (DE).
X represents control variables. 0 is drift component and is white noise.
In order to find out the short run coefficients, we use the following equation:
p p p
Yt 1 Yt i 2 FPt i 3 X t i ECtI (3)
i 1 i 0 i 0
1
See Appendix 1 for the definitions of variables.
500 Ali and Ahmad
is the error correction term in the model indicates the pace of adjustment reverse
to long run equilibrium following a short run shock.
Private investment is measured by the sum of business fixed investment,
residential investment and inventory investment. Moreover, current account balance is
measured by the sum of net exports of goods and services, net income from abroad (Net
Factor Payment) and net unilateral transfers.
Samudram and Vaithilingam (2009) in case of Malaysia and Mohammadi, et al.
(2008) in case of Turkey used Autoregressive Distributed Lag model (ARDL) to examine
the impact of public expenditure on economic growth.
To cope up with the endogeneity of explanatory variables, and to avoid
inconsistent results, this study uses two-stage least Square (2SLS) instrumental variable
techniques.
Table 1
Unit Root results
ADF (Drift and Trend) P- P (Drift and Trend)
Variables Level 1st Diff Level 1st Diff
Results show that each of the variables is integrated of different order. The
results of the unit root tests enable us to apply any cointegration technique. The
results of ADF and PP unit root tests show that all variables are integrated of order
one except PINV and CAD. The results of Ng-Perron unit toot test show that all
variables are integrated of order one except CAD. The results of Ng-Perron unit root
test are given in Table 2.
Effects of Fiscal Policy on Economic Growth 501
Table 2
Ng-Perron Unit Root Results
Ng-Perron Test Statistics
At Level
MZa MZt MSB MPT
Y 0.62 0.23 0.37 37.15
FD 36.0 134.29 0.01 0.01
PINV 9.69 2.12 0.21 9.71
PCON 1.79 0.49 0.27 24.08
INF 1.86 0.84 0.45 40.55
CAD 17.96** 2.99 0.16 5.07
At 1st Difference
MZa MZt MSB MPT
Y 17.61* 2.96 0.16 5.19
FD 3.76* 39.11 10.37 3.10
PINV 12.13*** 2.46 0.20 7.51
PCON 15.03*** 2.719 0.18 6.18
INF 55.82* 4.80 0.08 3.77
CAD 13.39** 2.58 0.19 6.80
Notes: *(**) Shows significance at 1 percent (5 percent) level.
Table 3
Lags Defined through VAR-SBC for Overall Model
Lag Selected through VAR-SBC
Lag Growth Equation
0 104.69
1 91.73
2 90.33*
3 90.55
Notes: *Indicates minimum Schwarz SBC at the corresponding lag.
502 Ali and Ahmad
Therefore, lag order 2 is selected on lowest value of SBC in Table 3 for the growth
equation. In the next step, we determine individual lag order for the estimation of ARDL,
which is (2, 2, 2, 2, and 0). Finally, the F-test Statistics is estimated on the basis of Wald-
test. The results are given in the following Table 4.
Table 4
Lag Length Selection and Bound Testing for Cointegration
Modal 1 (Growth Equation)
Order of the lags AIC HQ SBC F-test Statistics
K=1 116.65 118.57 117.28 2.31
K=2 113.98* 117.55* 115.17* 5.75**
Short run Diagnostic Tests
Serial Correlation LM tests = 1.65 (0.32)
ARCH Tests: 1.54 (0.24)
White Hetroscedasticity Test: 0.76 (0.34)
Ramsey RESET = 1.02 (0.87)
Jarque-Bera Tests= 897.45 (0.00)
*(**) Significant at 10 percent (5 percent) level of significant according to Pesaran, et al. (2001) and Narayan (2005).
Table 5
Estimated Long Run Coefficients Using the ARDL45
Dependent Variable ARDL Technique
Real GDP Growth Rate (Y) Order (2, 2, 2, 2, 0)
Regressors Coefficients Coefficients
FD 1.64* 1.04*
PINV 0.26 * 0.19*
INF 0.05** 0.06***
CAD 0.83* 0.91*
FD2 0.04*
FD *DUM 0.51***
R2 = 0.99 R2 = 0.99
Adjusted R2 = 0.99 Adjusted R2 = 0.99
F-statistics = 1298.2 F-statistics = 1576.2
Dh Stat = 2.14 Dh Stat = 1.81
Note: *, ** and*** represent Significant at 1 percent, 5 percent and 10 percent level of significance.
2
The results of CUSUM are given in Appendix 3.
3
For details see Pesran, et al. (2001).
4
ARDL order is (2, 2, 2, 2, 0) selected based on SBC.
Effects of Fiscal Policy on Economic Growth 503
5
To check the robustness of the model, we provide the results of 2SLS in Appendix 2. From the results
of both techniques (ARDL and 2SLS) it is clear that the parameters of the model are not sensitive to change in
econometric technique and hence, it shows the robustness of the model.
504 Ali and Ahmad
Table 6
Estimated Short Run Coefficients Using the ECM
Dependent Variable ARDL Technique
Change in Real GDP Growth Rate (Y) Order (2, 2, 2, 2, 0)
Regressors Coefficients
FD 0.28**
PINV 0.17***
INF 0.08*
CAD 0.98
FD*DUM 0.56
ECt1 0.43*
R2 = 0.81
R2 adjusted = 0.79
Note: *, ** and*** represent Significant at 1 percent, 5 percent and 10 percent level of significance.
The estimated lagged error correction term EC (1) is negative and highly
significant. The negative and significant error correction term also indicates that there is a
long run relationship among the variables Y, FD, PINV, INF and CAD. The feedback
coefficient is 0.43. It suggests that about 43 percent disequilibrium is corrected in the
current year. The result also suggests that in the short run fiscal deficit has significant
impact on economic growth. In the short run, increase in fiscal deficit leads to a decrease
in the real gross domestic product. However, in the short run changes in CAD and
FD*DUM have insignificant impact on economic growth.
Appendices
APPENDIX 1
DEFINITION OF THE VARIABLES
The definitions of all variables (explanatory variables and instrumental variables)
used in this study are given below.
Overall Budget Deficit/Surplus = (Current Account Expenditures + Development
Expenditures) (Repayment of Foreign Debt) (Net Revenue Receipts) (the
contribution by autonomous bodies) (The amount earned by disinvestment of shares).
Economic Growth = Growth rate in Real Gross Domestic Product (GDP)
Gross Private Domestic Investment = (Business Fixed Investment + Residential
Investment) + (Inventory Investment)
Current Account Balance = Net Exports of Goods and Services + Net Income
from abroad (NFP) + Net Unilateral Transfers
Inflation = Consumer Price Index (Inflation rate)
Public Debt = Total public debt as a percent of GDP.
Exchange Rate = Real exchange rate
Interest Rate = 6 months T- bill rate for short run and 9 months T-bill rate for
long run.
Money Supply = M1 + Saving Deposits including MMDAs (Money Market
Deposit Accounts) + Small Denomination time Deposits + MMMFs (Money Market
Mutual Funds).
APPENDIX 2
EMPIRICAL RESULTS USING 2SLS
Table 1
Estimated Coefficients Using 2SLS Techniques
Dependent Variable 2SLS
Real GDP Growth Rate (Y) Technique67
Regressors Coefficients
FD 1.11**
PINV 0.21*
INF 0.03***
CAD 0.69***
FD2
FD *DUM 0.12**
R2 = 0.97
Adjusted R2 = 0.96
F-statistics = 1532.06
Dh Stat = 1.86
Note: *, ** and*** represent Significant at 1 percent, 5 percent and 10 percent level of significance.
6
INT, M2, ER, PD and all of the variables in the growth equation that are believed to be uncorrelated
with the disturbances are used as instrumental variables.
Effects of Fiscal Policy on Economic Growth 507
APPENDIX 3
RESULTS OF CUSUM AND CUSUM SQ78
15
10
-5
-10
-15
-20
1980 1985 1990 1995 2000 2005
CUSUM 5% Significance
1.2
0.8
0.4
0.0
-0.4
1975 1980 1985 1990 1995 2000 2005
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